CHAPTER TWELVE TAXES AND INFLATION
TAXES IN THE U.S. • CORPORATE TAXES • forms of business are taxed differently • single proprietor and partnership income is taxed at personal income rates • corporate income may be taxed twice • once as it is earned using the corporate income rates • again as dividend income using the personal rates
CORPORATE TAX RATES • MARGINAL TAX RATES • are the most important for the corporation and represent the tax on additional income earned
CORPORATE TAX RATES • MARGINAL TAX RATES • are the rates on the next dollar earned
CORPORATE TAX RATES • MARGINAL TAX RATES: An Example Suppose a corporation earns $85,000 It pays .15 on first $50,000 = $7,500 .25 on next $25,000 = $6,250 .34 on next $10,000 = $3,400 Total tax on$85,000 = $17,150
CORPORATE TAX RATES • CALCULATING AVERAGE TAX RATE • the average tax rate = TOTAL TAX PAID TOTAL TAXABLE INCOME
CORPORATE TAX RATES • CALCULATING AVERAGE TAX RATE • the average tax rate is equal to the An Example $17,150 / $85,000 = 20.18%
PERSONAL INCOME TAXES • CALCULATING AFTER-TAX INCOME GROSS INCOME - ADJUSTMENTS ADJUSTED GROSS INCOME - DEDUCTIONS TAXABLE INCOME - TAXES AFTER-TAX INCOME
PERSONAL INCOME TAXES • EXAMPLE: A MARRIED COUPLE ARE EVALUATING AN INVESTMENT Assume: No Bracket “Creep” Taxable Income = $80,000 Marginal Tax rate = .28 Possible Investment Income: Tax (.28 x $3,000) = $840
PERSONAL INCOME TAXES • EXAMPLE: A MARRIED COUPLE ARE EVALUATING AN INVESTMENT Assume: Bracket “Creep” Possible Investment Income: $20,000 Tax .28 x 16,900 = $4,732 .31 x 3,100 = $ 961 20,000 = $5,693
PERSONAL INCOME TAXES • TAX-EXEMPT BONDS • DEFINITION: securities whose income is not subject to federal income taxes
PERSONAL INCOME TAXES • TAX-EXEMPT BONDS • most income from bonds issued by states, municipalities, and their agencies need not be included in taxable income for federal returns
PERSONAL INCOME TAXES • TAX-EXEMPT BONDS • to calculate fully-taxable-equivalent yield of a tax-exempt bond use the formula yield = __i__ 1 - t where t = the investor’s marginal tax rate i = the tax-exempt yield
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT • Less than one year ordinary income
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT • Less than one year ordinary income • 12 to 18 months max rate = 28%
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT • Less than one year ordinary income • 12 to 18 months max rate = 28% • more than 18 months 20%*
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT • Less than one year ordinary income • 12 to 18 months max rate = 28% • more than 18 months 20%* * unless taxpayer is in the 15% tax bracket in which case the rate = 10%
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT • Less than one year ordinary income • 12 to 18 months max rate = 28% • more than 18 months 20%* • five years or more 18%**
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT • five years or more 18%** ** Exception: If taxpayer is in 15% tax bracket, the asset must have been sold in the year 2001 or later, then rate = 8%
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES • CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT • Less than one year ordinary income • 12 to 18 months max rate = 28% • more than 18 months 20%* • five years or more 18%**
INFLATION IN THE U.S. • INFLATION • DEFINITION: the percentage change in a specific cost-of-living index at various points in time.
INFLATION IN THE U.S. • INFLATION • cost-of-living index • the “overall” price level computed for a “basket of goods”
INFLATION IN THE U.S. • PRICE INDICES • measure changes in prices relative to a fixed period in time usually called the base period
INFLATION IN THE U.S. • PRICE INDICES • the Consumer Price Index (CPI) is calculated by the U.S. Bureau of Labor Statistics in the Department of Labor
INFLATION IN THE U.S. • PRICE INDICES • the Consumer Price Index (CPI) is calculated by the U.S. Bureau of Labor Statistics in the Department of Labor • the Bureau uses a “market basket” of over 2000 U.S. consumer goods and services
INFLATION IN THE U.S. • NOMINAL AND REAL RETURNS • Fisher Model of Real Returns stated that real returns are important to investors • they represented how much purchasing power has changed
INFLATION IN THE U.S. • NOMINAL AND REAL RETURNS • price change may impact an asset’s nominal return
INFLATION IN THE U.S. • NOMINAL AND REAL RETURNS • adjustments to the nominal return are needed to remove the effects on purchasing power of inflation or deflation
INFLATION IN THE U.S. • NOMINAL AND REAL RETURNS • FORMULA FOR CALCULATING REAL RETURNS where C0 = CPI at the beginning of period C1 = CPI at the end of the period NR = the time period’s nominal return RR =the real return for the period
INFLATION IN THE U.S. • NOMINAL AND REAL RETURNS • a quick calculation of the real return NR - IR = RR where IR = the rate of inflation for the period NR= the nominal return RR= the real return
INFLATION IN THE U.S. • THE EFFECT OF INVESTOR EXPECTATIONS • investors’ attitudes toward inflation show they are concerned with real returns
INFLATION IN THE U.S. • THE EFFECT OF INVESTOREXPECTATIONS Looking to the future E(RR) = E(NR) - E(CCL) where E(RR) = the expected real return E(NR) = the expected nominal return E(CCL)= the expected inflation rate
STOCK RETURNS AND INFLATION • OVER LONG PERIODS OF TIME • common stocks generated large, positive real returns
STOCK RETURNS AND INFLATION • OVER LONG PERIODS OF TIME • T-bills produced much lower, positive real returns
STOCK RETURNS AND INFLATION • OVER SHORT PERIODS OF TIME • stock returns are not positively related to either actual or expected rates of inflation
STOCK RETURNS AND INFLATION • OVER SHORT PERIODS OF TIME • stock returns are positively related to both actual and expected rates of inflation
END OF CHAPTER 12
